The Effect of Less Desirous Debt

Federal tax reform could negatively affect the market for municipal bonds, increasing the cost of infrastructure projects for state and county governments.

Budget analyses prepared by the Department of Legislative Services for the General Assembly contain a wealth of information.

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The cost of borrowing could increase for State following federal tax reform, according to the Department of Legislative Services. The same effect could be seen in the county market for municipal bonds, a vehicle for local transportation infrastructure projects.

In this week’s presentation of the Operating Budget Analysis of Public Debt to the Budget and Taxation Committee, the Department describes how federal tax reform could decrease demand for municipal bonds with carry-over effects on the cost of debt for state and county governments.

The State of Maryland and counties use municipal bonds to finance a variety of public works projects, including transportation infrastructure.

From the Analysis’s Effect of Reducing Taxes on the State and Municipal Bond Market:

Most State GO bonds issued by the State are tax-exempt bonds. The purchaser of these bonds does not have to pay federal taxes on the bonds’ interest earnings. This makes these bonds especially attractive to individuals in high income tax brackets and corporations. This reduced the top bracket on individual taxes from 39.6% to 37% through calendar 2025 and reduces the top corporate income tax rate from 39% to 21% permanently. Lower tax rates reduce the amount of tax avoided by investing in tax-exempt bonds.

The Department describes the basis for this change:

  • Financial institutions, like banks and insurance companies, are estimated to own 25% of tax-exempt bonds. These institutions would require a higher interest rate to purchase tax-exempt bonds.
  • Some reports note that owners of pass-through entities, such as partnerships and Subchapter S Corporations, may also be less likely to purchase tax-exempt bonds, thereby dampening the demand and driving up prices.

DLS estimates the effect of these additional costs based on findings of a research firm’s data from the federal tax reform debates. DLS found that the State’s premium would have been reduced from $94 million to between $56 million and $69 million in its most recent bond sale in August 2017 because of higher rates.

For more information, see the Effect of Reducing Taxes on the State and Municipal Bond Market from the Budget Analysis.